Page 16 - CIMA SCS Workbook February 2019 - Day 2 Suggested Solutions

SUGGESTED SOLUTIONS

something Vita could consider. Although, given the article in “Online Technology Insight” where
companies are considering giving out activity trackers as an employee benefit, this may be

CHAPTER TEN

EXERCISE 1

Briefing paper

To: Paul Pau, CFO
From: Senior finance manager
Subject: Debt finance and assessing creditworthiness

DEBT FINANCE

Introduction

I have presented below the advantages and disadvantages of using debt finance compared to
using equity finance.

Advantages of using debt finance

Low cost of servicing the debt

The required return of a lender tends to be lower than the required return of a shareholder,
because the lender faces less risk (his returns are an obligation that can’t be avoided – see
“disadvantages” below for more details). This means that the cost of servicing the debt finance
(i.e. the cost of paying the required level of return to the investor) is cheaper than the cost of
equity.

Tax relief on interest

Interest paid to lenders is paid out of pre-tax profits, whereas dividends to equity shareholders
are paid out of post-tax profits. This means that the company gets tax relief on its debt interest,
making the cost of servicing the debt even cheaper still.

Impact on overall cost of capital

As a consequence of both the two factors identified above, bringing debt finance into a
company’s capital structure tends to reduce the company’s overall cost of capital, and hence
increase shareholder wealth.

According to Modigliani and Miller’s Gearing Theory, companies should raise large amounts of
debt finance to reduce the cost of capital. However, this theory is based on some assumptions
(such as perfect markets and no bankruptcy costs) which aren’t very likely to be replicated in the
real world.

Even so, an analysis of real world businesses (the Traditional View of Gearing) still shows that at
low or moderate levels of gearing a company can reduce its cost of capital by raising debt finance.

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